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RESPONSIBILITY AND SEGMENT
ACCOUNTING
Key Terms and Concepts to Know
Organizations: Centralized and decentralized organizations Business segments include cost centers, profit centers and investment centers.
Decentralization: The delegation of decision-making to lower levels of management. It is not possible for all decisions to be made by top management, especially in large and medium sized organizations. Responsibility accounting systems link decision-making authority with accountability for the outcomes of those decisions. Large and medium sized organizations are often divided into three types of responsibility centers: cost centers, profit centers and/or investment centers: o Cost Centers which may be evaluated through variance analysis o Profit Centers which may be evaluated by comparing actual income to budgeted income o Investment Centers which may be evaluated using Return on Investment or Residual Income
Fixed Costs: Traceable fixed costs are incurred for the benefit of one business segment and are controllable by the segment Common fixed costs are incurred for the benefit of more than one segment and are not traceable to or controllable by any one segment. There are numerous approaches to the allocation of common fixed expenses to business segments Problems caused by arbitrarily dividing common costs among segments
Segment Performance Evaluation: Information from the Segment Income Statement is an input for two methods: o Return on Investment (ROI) method o Residual Income method
Key Topics to Know
Evaluation of Management Performance
Managers of the cost centers, profit centers and/or investment centers are held responsible for the results of their particular segment. This is referred to as responsibility accounting. Each segment may prepare a Segment Income Statement income statement that reports the revenue, variable expenses, contribution margin and traceable fixed expenses controllable by segment management. The highlight of the segment income statement is the Segment Margin, computed as segment contribution margin less the segment’s traceable fixed costs. It represents the segment’s income after all the traceable fixed costs have been covered. Some companies then deduct the segment’s share of common or allocated fixed expenses to calculate the segment’s operating income. In addition to the segment income statement, segment performance may be evaluated using either Return on Investment or Residual Income.
Return on Investment
ROI measures the segments ability to utilize its operating assets to generate income. ROI focuses on how efficiently the assets are used since it expressed as a percent of the assets used. The ability to generate income by utilizing operating assets varies widely by industry and by company within an industry. Return on Investment (ROI) has three interrelated formulas:
ROI =
Net operating income Average operating assets
ROI = Margin X Turnover
ROI =
Net operating income X Sales Sales Average operating assets
Margin = Net Operating Income / Sales or the ability to keep a portion of sales dollars in the business as income Turnover = Sales / Average Operating Assets or the ability to use operating assets to generate sales
Example #
Omaha Company provides the following information:
Sales $4,000, Net operating income 400, Average operating assets 1,600,
Required: a) Compute the company’s return on investment. b) The owner is convinced that sales will increase next year by 150% and that net operating income will increase by 100%, with no increase in average operating assets. What would be the company’s ROI? c) The chief financial officer of the company believes a more realistic scenario would be a $1,000,000 increase in sales, requiring a $400,000 increase in average operating assets, with a resulting $250,000 increase in net operating income. What would be the company’s ROI in this situation?
Solution #
a) ROI =
Net operating income $400, = 25% Average operating assets $1,600,
b) ROI = Net operating income $400,000 + 400, = 50% Average operating assets $1,600,
c) ROI = Net operating income $400,000 + 250, = 32.5% Average operating assets $1,600,000 + 400,
Example #
Snickers Company has two investment centers and has developed the following information: Department A Department B Net operating income $120,000? Average operating assets? $400, Sales 800,000 250, ROI 10% 12%
Required: a) What was the amount of Department A's average operating assets? b) What was the amount of Department B's net operating income? c) If Department B is able to reduce its operating assets by $100,000, what would be Department B's new ROI? d) If Department A is able to increase its net operating income by $60,000 by reducing expenses, what would be Department A's new ROI?
Solution #
a) Net operating assets $120,000 =$1,200, ROI 10%
b) Average operating assets X ROI $400,000 X 12% = $48,
c) Net operating income $48, = 16% Net operating assets $400,000 – 100,
d) Net operating income $120,000 + 60, = 15% Net operating assets $1,200,
Residual Income
An alternative measurement tool to ROI is Residual Income, which focuses on the ability of operating assets to generate dollars of income, not how efficiently the operating assets were used. Residual income is the amount by which actual operating income exceeds the minimum required income. Minimum Required Income = Required Rate of Return X Average Operating Assets Residual Income = Net Operating Income minus Minimum Required Income
Practice Problems
Practice Problem #
Stockholm Company produces and sells two packaged products, Product W and Product Z. Revenue and cost data relating to the two products is as follows: and in addition common fixed expenses not traceable in the company total $44,000 per year. Last year the company produced and sold 18,000 units of Product W and 30,000 units of Product Z. The selling price of W is $8 per unit and the selling price of Z is $12 per unit. Variable expenses of W are $5.50 per unit and Z $8.75 per unit. Traceable fixed expenses per year are $15,000 for W and $65,000 for Z.
Required: Prepare a contribution format income statement segmented by product lines.
Practice Problem #
Madison Company Electronics Division provided the following annual data for 2009:
Sales $8,000, Net operating income 1,000, Average operating assets 4,000,
Required: Compute the margin, turnover and return on investment.
Practice Problem #
For the year, Lansing Company had net operating income of $1,500,000 with sales of $4,000,000. The company’s average operating assets for the year were $8,000,000 and its minimum required rate of return was 15%.
Required: Compute the company’s residual income.
Practice Problem #
Lafayette Company has 3 divisions: X, Y, and Z with the following data for the year:
X Y Z Sales A 80,000 G Net operating income B 20,000 6, Average operating assets 100,000 D H Margin 4% E 7% Turnover 5 F I ROI C 20% 14%
Required: Compute the missing amounts above.
Practice Problem #
The Homer Company manufactures basketballs. Last year’s sales were $700,000, net operating income was $100,000, and average operating assets were $800,000.
Required: a) If next year’s sales are unchanged and expenses and average operating assets are reduced by 10%, compute next year’s ROI. b) If the minimum required rate of return is 6%, what will be the residual income next year?
Practice Problem #
The Water Management Company evaluates the performance of the Service and Irrigation Divisions using the return on investment (ROI) measure. The following information pertains to the two divisions as of the end of the current year.
Service Irrigation Total Units 8,000 250 Investment $400,000 $1,000,000 $1,400, Expenses: Direct materials 40,000 400,000 440, Direct labor 200,000 200,000 400, Overhead 25,000 250,000 275, Selling costs 15,000 150,000 165, Total Expenses $280,000 $1,000,000 $1,280,
True / False Questions
- The most common method of evaluating a profit center manager is the segmented income statement. True False
- Investment center managers have control over the investment of assets. True False
- Segment margin and operating income are identical terms. True False
- Turnover is defined as the ratio of sales revenue to average invested assets. True False
- Margin is defined as the ratio of sales revenue to operating income. True False
- All other things the same, if a division's traceable fixed expenses decrease the division's segment margin will increase. True False
- All other things the same, a decrease in average operating assets will increase return on investment (ROI). True False
- When used in return on investment (ROI) calculations, operating assets include investments in land held for future use and investments in other companies. True False
- Residual income is primarily useful because it helps to compare the performance of divisions of different sizes. True False
- A decentralized organization is one in which decisions are made by top management and then implemented by managers at lower operating levels. True False
- An investment center is any responsibility center in an organization that controls cost and revenues and invested funds. True False
- The same cost can be traceable or common depending on how the segment is defined. True False
- In general, common fixed costs should be assigned to segments. True False
- If a company eliminates a segment of its business, the costs that were traceable to that segment should disappear. True False
- If four segments share $800,000 in common fixed costs and one segment is eliminated, the common fixed costs will decrease by $200,000. True False
7. Which of the following statements^ states a proper level of control?
a) A profit center manager should be evaluated based on residual income, not ROI b) An investment center manager should be evaluated based on ROI, not residual income c) A profit center manager should be evaluated based on segment margin, not operating income d) A cost center manager should be evaluated on costs and revenues, not just costs
8. Investment turnover can be calculated as
a) Sales revenue/average invested assets b) Operating income/sales revenue c) Operating income/average invested assets d) Average invested assets/sales revenue
The next 2 questions refer to the following information. Arbor Co. has an operating income of $120,000 on revenues of $1,000,000. Average invested assets were $600,000. Arbor requires an 8% minimum rate of return.
9. What is the return on investment?
a) 8% b) 10% c) 12% d) 20%
10. What is the^ profit margin?
a) 8% b) 10% c) 12% d) 20%
11. Minneapolis Corp. has an ROI of 10% and a residual income of $10,000. If
operating income equals $20,000, what is average invested assets? a) $200, b) $66, c) $450, d) $150,
12. Iowa City Inc.^ has a profit margin of 12% and an investment turnover of 2.5.
Sales revenue is $600,000. What is the operating income? a) $180, b) $28, c) $72, d) $240,
13. Iowa City Inc.^ has a profit margin of 12% and an investment turnover of 2.5.
Sales revenue is $600,000. What is average invested assets? a) $240, b) $1,500, c) $50, d) $72,
14. Columbus Corp. has revenues of $1,500,000 resulting in an operating income
of $105,000. Average invested assets total $750,000. Calculate the ROI if sales increase by 10% and the profit margin remains constant. a) 7.7% b) 14% c) 15.4% d) 7.0%
15. Columbus Corp. has revenues of $1,500,000 resulting in an operating income
of $105,000. Average invested assets total $750,000. If sales increase by 10% and the investment level remains constant, what is the investment turnover? a) 2. b) 2. c) 7.0% d) 7.7%
16. Urbana Corp. has sales revenue of $500,000 resulting in operating income of
$54,000. Average invested assets total $600,000, and the cost of capital is 6%. Calculate the return on investment if sales increase by 10% and the profit margin and invested assets remain the same. a) 9.0% b) 9.9% c) 10.8% d) 6.0%
Solutions to Practice Problems
Practice Problem #
W Z Total Sales $ 144,000 $ 360,000 $ 504, Variable Expenses 99,000 262,500 361, Contribution Margin 45,000 97,500 142, Traceable Fixed Expenses 15,000 65,000 80, Product Segment Margin $ 30,000 $ 32,500 62, Common Fixed Expenses 44, Operating income $18,
Practice Problem #
Margin = Net operating income =
Sales 8,000,
Turnover = Sales =
Average operating assets 4,000,
ROI Margin X Turnover = 12.5% X 2.0 = 25.0%
Practice Problem #
Average operating assets $8,000, Minimum rate of return 15% Minimum required income $1,200, Net operating income $1,500, Residual Income $300,
Practice Problem #
In the order solved:
C Margin X Turnover 4% x 5 = 20% B ROI X Average operating assets 20% x $100,000 = $20, A Net operating income / Margin $20,000 / 4% = $500,
E Net operating income / Sales $20,000 / $80,000 = 25% F ROI / Margin 20% / 25% =. D Sales / Turnover $80,000 / 1 = $100,
I ROI / Margin 14% / 7% = 2 H Net operating income / ROI $6,000 /14% = $42, G Net operating income / Margin $6,000 /7% = $85,
Practice Problem #
a) Last Year Change Next Year ROI: Net operating income $100,000 $60,000 $160, = 22.2% Average operating assets 800,000 (80,000) 720,
Change in Income: Sales $700, Net operating income 100, Expenses 600, Decrease % 10% Decrease in expenses $60,000 = Change in Income
b) Residual Income: Average operating assets $800,000 $720, Minimum rate of return 6% 6% Minimum required income $48,000 $43, Net operating income $100,000 $160, Residual Income $52,000 $ 116,
Solutions to True / False Problems
- True
- True
- False - Segment margin does not include common fixed expenses which are not traceable to a particular segment.
- True
- False - Margin is the ratio of operating income to sales revenue.
- True
- True
- False - Operating assets do NOT include investments in land held for future use and investments in other companies. These are not part of operating assets. Operating assets may be described as assets which are necessary to carry on the day to day activities of a business.
- False - Residual income is the excess of income over a stated minimum return. It is not useful in comparing various divisions
- False - A decentralized organization is one in which decisions are made by managers at lower operating levels and implemented by those managers.
- True
- True
- False - Common fixed costs should NOT be assigned to segments. These are costs that are incurred for the benefit of the entire organization and NOT easily traceable to a particular segment.
- True
- False - Common fixed expenses should NOT be affected by the elimination of one segment. No decrease would be expected.
Solutions to Multiple Choice Questions
1. B
2. B
3. A
4. B
5. C
6. B
7. C
8. A
9. D
10. C
11. A
12. C
13. A
14. C
15. B
16. B
17. B
18. D
19. A
20. D
21. A
